Educational Articles

Industry Analysis: Recreation

Alan G. House

The Recreation Industry is one of the more cyclical sectors under Value Line coverage. Products and services that are identified with this industry are generally discretionary in nature. Thus, during times of economic prosperity sales and earnings generally flourish. On the other hand, when times are tough, and consumers' pocketbooks stay closed, bottom lines tend to flounder. Companies found in our Recreation Industry sell a myriad of offerings, ranging from small toys to motorcycles to exotic cruises. Those that sell small-ticket items tend to fare the best in a lackluster economy.

Income Statement

Recreation Industry revenue is highly dependent on the introduction of new, interesting products and services. Competition is quite intense for the most part, particularly when economic times are less promising, so companies must lure potential customers with flashy new items. That said, research and development is a key line item to monitor on a recreation company's income statement.

There is no "rule of thumb" with regard to what percent of revenue this item should be for a typical corporation in this sector, because of the vast differences in products and markets served. The best way to analyze R&D is to compare the current figure to past quarter tallies. A significant decline, especially in favorable economic times, could be a sign of trouble.

Another factor that investors should be cognizant of is "fad" items. Such products can lead to incredible gains in sales over short periods of time. Scooters, roller blades, even bicycles, when they were first invented, helped to ignite profits and consequently share prices. However, all good things must come to an end, and when a fad hits the skids, bottom lines usually suffer. Hence, investors should take a closer look when a company reports outsized profits for a quarter or two. Typically, the decline in the company's stock price is at least as severe in magnitude as its ascent.

Margins in this industry tend to be a bit above the Value Line average. For the most part, companies can pass along increased raw material costs to customers, particularly during better economic times. However, during less stellar conditions, cost-cutting becomes increasingly important. Measures that can be enacted to reduce costs include employee downsizing, facilities consolidation, manufacturing efficiency improvement, and among others, productivity enhancement.

Cash Position

Balance sheets across this industry differ immensely. Certain companies, such as those in the amusement park and cruise ship segments, tend to be highly leveraged, having heavy capital needs. This does present a high barrier to entry, though, limiting competition. Other companies are much less capital-intensive, and thus, have lower debt levels.

One significant line item to watch, particularly during difficult economic times is cash on the ledger. Indeed, a company's "cash-burn" rate is significant. Companies that have a large cash account, funded by operations, and use it sparingly, fare the best. A company with substantial excess cash has much flexibility to purse an acquisition. Acquisitions within the Recreation sector are usually small, bolt-on ones. Such deals complement existing product portfolios and/or provide access to new geographic areas.

Share buybacks or dividend increases are also possible uses of excess cash, which directly reward stockholders. That said, investors should be mindful of companies that have very high payout ratios (over 50%). In such cases, there may be scarce funds for new product development, a crucial element of long-term earnings growth.

Investment Considerations

Price-to-earnings multiples of stocks in the Recreation Industry have historically mirrored the broader market averages. Thus, for the most part, their Price Stability ratings tend to be rather decent.

There are many other considerations, some of which we discuss here, to consider before investing in a recreation stock. One might ask: What are a company's earnings prospects in sluggish times, or a recession? Stocks within this industry are not considered "defensive", so most will be hard hit when consumers' wallets are pinched. Some companies cannot cover costs as well as others during an economic downturn. Many have high fixed costs, which are burdensome at the bottom line when revenue falls off. Those whose costs are more variable in nature tend to fare better, since the benefit of any production cuts will easily translate into increased net profit.

Investors should also pay close attention to a company's balance sheet. A general rule of thumb for industrial (and recreation) companies is that the debt-to-total capital ratio should be about 35%. However, some companies are much more highly leveraged than others due to the capital-intensive nature of their industry. A high debt burden can be particularly cumbersome, though, when interest rates are rising or a tough business climate is squeezing margins.

Sustainability of earnings growth is another consideration worth keeping an eye on. For instance, an investor might ask: Is a recreation company benefiting from a "demographic trend" that will subside over time or go away if conditions change? For example, if the birth rate should decline significantly, this would surely have a negative impact on toy makers down the road.

All said, investors should study each individual company for its own merits before committing funds.